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A Consumption Tax: Now, That's Tax Reform

As Apr. 15 approaches, are you ready to blow the U.S. tax code to smithereens? Well, the fuse is about to be lit--by four powerful U.S. senators known, until now, for their moderation.

Within the next few weeks, the lawmakers will introduce two separate bills that are designed to replace much of the cumbersome Internal Revenue Code with a national consumption tax. One of the measures will be sponsored by Senate Finance Committee members David L. Boren (D-Okla.) and John C. Danforth (R-Mo.). The other bill will be put forth by Senators Pete V. Domenici (R-N.M.) and Sam Nunn (D-Ga.). When these four step forward, other politicians, business executives, and ordinary voters will get a glimpse of life after the income tax.

What the lawmakers hope to achieve is long overdue. Judging correctly that the current tax system encourages consumption, they propose schemes to spur growth by encouraging savings and investment. It's a concept that has fascinated economists for years. Now, finally, "there is a widespread view across the political spectrum that the present tax system is wrong," says Danforth. "The time has come to change this."

The proposals are farther-reaching and promise to be more controversial than even the 1986 Tax Reform Act. For the first time, though, consumption taxes are about to get a bipartisan push onto the political stage. "It forces examination of every issue on the table," says Barry Rogstad, president of the American Business Conference, a group of midsize growth companies that back tax-code reform.

FIRST VOLLEYS. Both bills would eliminate the corporate income tax and substitute a consumption levy--without changing total tax receipts. Although the versions will differ in the details, each plan would have companies subtract all purchases of goods and services from gross income and pay a tax of around 10% on the difference. That means capital equipment, inventories, and the like would be written off in the year they are acquired, rather than depreciated over several years. Businesses would no longer deduct the cost of labor, debt, or equity financing. To make the new system meld with foreign tax laws, revenues from the sale of exports would be excluded from taxation, while the cost of imported goods would be included.

Nunn and Domenici would go a step further: They would replace the personal income tax with a sort of super-individual retirement account, in which savings and investment are tax-free. Americans could invest in stocks or mutual funds or put money in the bank, and it all would be subtracted from their incomes. They would be taxed at rates ranging from 14% to 40% on the balance.

The two bills will get their first public airing at the Entitlement Reform Commission, a deficit-reduction panel established by the White House and co-chaired by Danforth. That will be just the first step, however, in what promises to be a protracted legislative struggle. Both of the proposals avoid the controversial approach of a value-added tax: That levy, already imposed in many countries, has had little impact on national savings rates and can be costly to administer.

Surely, though, there's plenty of fodder in these proposals for critics. State and local governments will fear losing their ability to sell tax-exempt bonds, since all investments would be, effectively, tax-free. Homebuilders, educators, and other sellers of big-ticket goods and services will argue that the purchases of their products should be considered tax-free investments rather than taxable consumption. Retailers would get little benefit from the big tax breaks on capital equipment but may face increases in the aftertax costs of labor and imports. And the elderly, who tend to spend a high proportion of their income, fear their taxes will rise.

NEW THINKING. Proposals this far-reaching can never become law without the White House's support. Back in 1992, Bill Clinton ridiculed a version of the consumption tax offered by Democratic rival Jerry Brown. These days, Clinton is taking the idea seriously, though he might prefer to postpone tax reform until a second term. The Progressive Policy Institute (PPI), a Washington think tank with close ties to the President, has been studying the issue for nearly a year, searching for a broad-based tax regime that would enhance the economy's long-term growth. Says PPI Vice-President Robert J. Shapiro: "You can't do this by tinkering."

Precisely. The U.S. needs to have a serious debate on issues such as raising national savings and taxing labor and capital fairly and efficiently. The dialogue won't be joined as long as Congress dithers over meaningless balanced-budget amendments such as the one defeated Mar. 1 in the Senate. Nunn, Domenici, Danforth, and Boren are about to lay out some serious proposals. They may not have all the right answers. But they are--at last--asking the right questions.Howard Gleckman